The global venture capital (VC) market continues to boom, and so entrepreneurs often believe that VC firms will readily fund their idea, product or service. The reality, though, is that securing funding is difficult, and many companies miss out on capital because their founders do not understand the fundamentals of VC. In this comprehensive, accessible primer, consultants Susan Hyttinen and Elmo Pakkanen discuss the VC essentials that start-ups need to know to become viable investments. Entrepreneurs, start-up executives and investors will discover valuable insights in this informative report.
- Venture capital (VC) firms seek out early-stage companies with the potential for high returns.
- The VC model depends on a few companies delivering outsized results, because many businesses fail and investments are lost.
- VC firms look for “unicorns” and identify candidates based on people, product and market.
Venture capital (VC) firms seek out early-stage companies with the potential for high returns.
VC is a staple ingredient for start-ups and early-stage companies. However, venture capitalists have specific parameters and frameworks for allocating funds to emerging companies, and many young firms do not qualify for funding under the VC architecture. To secure VC dollars, start-up founders need to understand the nuances of the model. First and foremost, venture capitalists seek high returns, given the greater risk associated with entrepreneurial firms.
“VCs can’t fund your company – no matter how promising – if the size of the opportunity isn’t large enough.”
A VC general partner (GP) is the final arbiter in deciding whether an investment will occur, using funding from limited partners (LPs) that include insurance companies, pension funds and wealthy individuals. VC firms typically focus on areas in which they have sector experience. Some VCs manage micro funds with assets of less than €1 million [$1.06 million], while other funds maintain billions in assets.
The VC model depends on a few companies delivering outsized results, because many businesses fail and investments are lost.
A standard 10-year timeline for investing in, and holding, companies in portfolio consists of an “initial investment period, portfolio development period and exit period.” VC firms usually manage multiple funds in different stages.
“The VC model doesn’t work by making a little bit of money on a lot of deals, but instead by a few select deals bringing in extreme outlier returns.”
A breakdown of a €50 million fund illustrates the inner workings of this diversified approach. In the initial investment period, a typical VC fund may first allocate €20 million across 20 companies to seed their operations. In the development phase, the GP will fund the most promising businesses with an additional €20 million, with the goal of exiting the investments through M&A or an IPO. The remaining €10 million covers the VC’s fees and expense charges. On average, of the 20 selected companies, 10 will fold, eight will deliver minor returns and only two will produce mega results. For example, Y Combinator exited its $20,000 investment in AirBnb for $2.25 billion, and Sequoia invested €56.17 million in WhatsApp and reaped €2.81 billion.
VC firms look for “unicorns” and identify candidates based on people, product and market.
VCs covet unicorns, those early-stage companies with valuation potentials of €1 billion or more. LPs invest based on a fund’s track record of success in identifying potential unicorns. GPs looking for unicorns assess a start-up’s people, especially the founder, for their skills, integrity and resolve. A GP will consider how well their product solves a problem and the need for it. And in their market analyses, VCs bear down on the size and growth prospects of a business’s “total addressable market.”
“The VC model works most optimally for start-ups with specific traits, namely those that are massively scalable and capital efficient, can go through rapid iteration cycles, and have recurring revenues and low marginal costs – which often best describes software start-ups.”
Many start-ups may not qualify for VC funding, but alternative sources include angel investors and venture debt.
About the Authors
Susan Hyttinen and Elmo Pakkanen are professionals at Soaked by Slush.